Can Dematerialization of Securities Tackle Startups' Angel Tax Woes?

The Ministry of Corporate Affairs (MCA) recently issued a notification mandating the dematerialization of securities for unlisted private companies, excluding small companies. This move is expected to have a profound impact on startups, aligning with the recommendations of industry experts who proposed dematerialization as a means to address issues related to angel tax concerns. Beyond this, the new guideline aims to enhance transparency, reduce the risks associated with fake certificates and fraudulent share transfers, and ultimately benefit the Indian entrepreneurial ecosystem.

Talking to TICE News, Mr Anil Joshi, Managing Partner, Unicorn India Ventures said, "The dematerialisation will certainly help companies and regulators in better monitoring but the process will add extra burden on the companies especially for maintaining the demat formalities."

Let’s have a look at what dematerialization means, its impact on startups and its benefits.

What Are The New Guidelines on Dematerialization?

The latest notification, issued by the MCA on October 27, 2023, has introduced two significant amendments to the rules under the Companies Act, 2013 — the Companies (Management and Administration) Second Amendment Rules, 2013 and the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023. These amendments are aimed at enhancing transparency in the administration of corporate affairs.

The MCA's notification requires private companies to issue securities solely in dematerialized form and ensures the dematerialization of existing securities held by promoters, directors, and key managerial personnel. This new mandate, issued by the MCA, is a significant step toward improving overall investor protection in unlisted private companies.

The amendments stipulate that no private company can issue securities or buy back its securities after September 30, 2024, until the entire holding of securities of its promoters, directors, and key managerial personnel has been dematerialized. Additionally, every holder of securities in a private company who intends to transfer such securities on or after September 30, 2024, must dematerialize them before the transfer.

Furthermore, all subscriptions to any securities of a private company, whether by way of private placement, bonus shares, or rights offers on or after September 30, 2024, can only be made in respect of securities held in dematerialized form.

Who Are Exempted from The New Guidelines?

Small private companies with a capital of less than Rs 4 crore and a turnover of less than Rs 40 crore, as well as those that are neither holding nor subsidiary companies, will be exempt from the burden of dematerialization, providing relief to these enterprises.

How Will The MCA’s New Guidelines Impact the Startups?

The move is expected to benefit startups and is in line with the recommendations of industry experts who suggest proposed dematerialization as a measure to address issues related to angel tax concerns.

The mandated demat rule is applicable to private companies, which have paid-up capital exceeding Rs 40 million or turnover exceeding Rs 400 Million. The paid-up capital threshold is of lesser concern for startups since they often have higher valuations and tend to issue shares at a premium, resulting in a lower paid-up capital base. However, the turnover threshold could pose a challenge for startups, as many are valued based on gross merchandise value.

As per the MCA notification, any company making offers for issuing securities, conducting buybacks, issuing bonus shares, or rights offerings after the compliance deadline must ensure the dematerialization of the entire holdings of securities held by its promoters, directors, and key managerial personnel. Additionally, individuals holding securities of private companies are also required to have their shares dematerialized.

The dematerialization of shares has been a long-standing demand for private companies. Startups, as they scale, often choose to dematerialize their shares as it simplifies shareholder management and facilitates faster exits.

The move is likely to bring transparency in ownership and is now seen as the streamlining of one of the most complicated tax regimes on the cards.

Mr Anil Joshi said, "The dematerialisation was expected and infact MCA has indicated in past on the same, the same has been now implemented for all pvt ltd companies except small companies. The criteria for small companies yet to be seen but other than the small companies all companies will be required to demat the securities by September 24. The objective is to digitise and bring transparency, however this may restrict companies who would raise money from foreign investors as even they will be required to have a demat account for holding securities. The foreign investors may find it cumbersome to open and manage demat account and will restrict startups raising foreign currency investment if Investors shy away from the formalities. Overall it is good initiative and will bring transparency in the process and also easy to manage the investor relations. I am sure MCA may tweak policy post identifying issues, so that the process can be made smooth."

Dematerialization: What It Means and Its Benefits

Dematerialization is the process of converting physical share certificates into an electronic format, eliminating the need to maintain physical copies of securities. It involves the creation of electronic versions of physical shares and securities, a practice already in place for listed public companies in India.

How and When Did Dematerialization of Shares Begin in Indian Equity Markets?

The dematerialization of shares in Indian equity markets began in 1996 with the establishment of the National Securities Depository Limited (NSDL). This development revolutionized the way shares were held and traded, leading to increased efficiency, transparency, and investor participation while reducing the risks and costs associated with physical certificates. It was a pivotal moment in the evolution of India's capital markets.

The MCA's move to mandate the dematerialization of securities for unlisted private companies is a significant step toward enhancing the integrity of India's financial markets. This initiative aligns with the global trend of transitioning to electronic record-keeping and promises to bring more transparency and security to the world of startup investments. It is expected to streamline operations, reduce disputes, and create a more investor-friendly environment in the Indian startup ecosystem. With a deadline set for September 2024, affected companies will need to act swiftly to comply with the new guidelines, ensuring a seamless transition to dematerialized securities.

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